The quality and quantity of ESG reporting is improving, but it comes with costs that firms are reluctant to pass on to clients in such a competitive market. And many still neglect to report failures. Managers from Crestbridge, UBP, Kleinwort Hambros and 7IM discuss costs and other market realities.
Now being labelled as the ultimate risk tool in COVID times, we are asking companies across the investment spectrum for a mid-term report on ESG. How are managers explaining it to clients, cutting out greenwash, and using budgets to produce credible data on how funds and companies are performing on environmental, social and governance factors, now arguably more critical than ever. And, given the uneven reporting landscape, should managers legitimately be advising clients to double down on companies with lower ESG risk scores to reduce their volatility in a bear market? On these subjects and others, we hear from investment managers at Crestbridge, UBP, Kleinwort Hambros and 7IM.
MiFID II and other regulations have the industry says squeezed available sell-side research with no new research filling the gaps. This being the case, how do managers see it affecting ESG strategies? And what can be done?
Daniela Klasen-Martin, head of management company services at Crestbridge, believes one solution lies in asset management firms developing their own research budgets. "The cost of these either comes out of the asset manager’s own pocket or is passed on to clients via pre-agreed research payment accounts,” she said, adding that there may be a squeeze in the short term, but it shouldn’t last long. Asset managers should either expand their own proprietary research team, increase expenditure on external research, or some combination of the two, she said. "Sell-side firms need to establish a price for investment research separately from execution services, with these rules applying across asset classes."
Klasen-Martin points to a recent survey by the CFA Institute on where managers are heading. A majority – 78 per cent – said they expected to source less research from the sell-side under MiFID II, suggesting more activity coming in-house, with around half indicating this as the case. There "appears to be unanimity” that ESG research is integral but “who pays" remains the question, Klasen-Martin said. As demand for ESG research increases, she sees larger firms as the main beneficiaries. Camilla Ritchie, senior investment manager at 7IM, agrees that the landscape will only get more “onerous" in producing the ESG reporting clients are demanding and "put pressure on costs.”
How ESG factors are applied across the different asset classes is a mixed bag for investors. "Investing in a direct equity or bond, for example, requires a differing research approach, reviewing single company metrics compared with investment in a unitised product," said Kleinwort Hambros' head of product strategy, Delyth Richards. "We currently find the greatest challenges are in investing in hedge fund strategies. Typical scoring (eg, MSCI ESG) is less evolved across this asset class compared to equity and bond funds. Our investors look to us to guide them and advise them," she said.
There’s no doubt that the quality and quantity of ESG reporting is improving, Klasen-Martin said, noting recent research by the Governance and Accountability Institute showed that 86 per cent of S&P 500 companies had published sustainability reports in 2018, up from roughly 20 per cent doing so in 2011.
Firms are “ramping up their investment in ESG reporting and due diligence", which has spawned many third-party firms offering similar services, Klasen-Martin said, mentioning Refinitiv as one example. In April the firm announced an enhanced ESG scoring methodology, which measures a company’s relative ESG performance, commitment and effectiveness across 10 main themes, including emissions, environmental product innovation, diversity and inclusion, human rights, shareholders, and so forth, she said. The purchase of Refinitiv by the London Stock Exchange Group last year for $27 billion marked a turning point in the data analytics space.
Asked where client reporting can be improved, Klasen-Martin responded that standardisation across the multiple reporting frameworks is a start. “Many firms use GRI (Global Reporting Initiative) reporting, but the Sustainability Accounting Standards Board (SASB) is often the preferred framework for investors because it provides greater transparency and better risk management, she said. "External auditors can also be used as a source of reliable and impartial assessment."
It is also critical that firms don’t “omit their mistakes and failures," she added. "They shouldn’t only report on their sustainability success stories, but the areas where they are lagging behind as well. How else are firms going to increase investor confidence, provide greater transparency, and prevent ‘greenwash?".
Jason Ulrich, head of responsible investment in Wealth Management at Union Bancaire Privée, largely agrees that ESG is still in its infancy, short on industry standards and data allowing managers to "make forward-looking, value-added ESG investment decisions. Efforts by SASB and the Task Force on Climate-related Financial Disclosures (TCFD) to codify ESG disclosure standards should help efforts to improve data quality and impact," Ulrich said.
Next steps will be combining material non-financial data with financial data to give investors and managers a better understanding of ESG alpha and what that entails, including its impact on volatility and expected return. "The integration of more forward-looking climate-related scenarios is also an important element for future reporting."
But ESG comes with costs, Ulrich said. "Given industry trends, it is hard to pass costs directly on to the client, especially in such a competitive area. Innovative investment companies might be able to position themselves differently and offer an attractive product, allowing them to charge more in order to offset some of the greater cost," he said. But with ESG assets under management growing fast, he expects costs to fall. Klasen-Martin agrees that extra reporting demands will bring short term cost pain. "But without it, firms may find it more difficult to attract capital in the future," she said. But progress is still slow.
A year ago, the World Resources Institute asked investors what the major stumbling block were. “They identified poor coverage across the portfolio, immaterial or generic language rather than robust quantitative KPIs, and inconsistent third-party evaluation." Klasen-Martin said. A year on, these same problems exist.
Another issue is how much ESG scrutiny exists for private firms, and what public markets can learn from private ones for screening companies’ ESG practices.
For 7IM, analysis of private companies is limited, Ritchie said. "As a UCITS compliant fund manager, direct investment in private equity is not permitted largely because of the lack of liquidity these investments provide. However, 7IM funds can invest in listed private equity funds which provide daily liquidity; although finding one focused on ESG investing is difficult," she said. "Using private equity techniques to analyse publicly listed companies is useful; especially for early stage companies that are growing fast," Ritchie added.
Ulrich at UBP sees direct investing in individual companies as still the most flexible way of implementing clients' ESG ideas, both "through exclusion and integration of various ESG aspects", but said exclusion is still likely to dominate. "Most private investors are only just embarking on this new ESG journey," but more sophisticated approaches like impact investing and active ownership are becoming more important, he said. "Hedge funds are still at a very early stage of trying to take responsible investment and ESG considerations into account, both as regards fund management but also in terms of transparency, liquidity and reporting."
Asked how ESG can help frame investment through high volatility times, Crestbridge's Klasen-Martin said that it is still too early to tell. "However, it may prove to be the case that ESG investments within portfolios will emerge relatively well," she said. "The sectors seemingly most affected by COVID-19 – oil, retail, travel etc. – are those which ESG funds, by their very nature, steer clear of. This could potentially see greater capital allocation to ESG causes in the short to medium term. Similarly, in the long term, investors may see these causes as a hedge against potentially similar situations, so there could be even greater allocations to ESG in the future."